2012 Vol. 2

>>2012 Bulletin, Volume 2

Certain derivative products such as variance swaps and VIX futures offer direct exposure to volatility as an investment. This note overviews the payoffs from volatility exposure and how they are viewed in the academic literature. It then discusses how an investor's approach to volatility exposure should vary across products and investors. Two key features of volatility payoffs stand out. First, (long) exposure to volatility has traditionally provided an equity market hedge, but has been associated with negative payoffs - the so-called volatility or variance risk premium (VRP). Second, the magnitude of the VRP has varied significantly across products, being most clearly manifest in shorter-dated VIX futures and variance swaps. The implication is that differing products might be preferred for return enhancement versus hedging. Further, whether an investor views volatility exposure as a return source or a hedge may depend on aspects such as their objectives, risk aversion, investment horizon and reference portfolio.

Investing in volatility as an asset class (VIX®) has been the subject of much discussion in the investment community in recent years because of its potential use as a portfolio diversifier. Defined generally as the 30-day rolling standard deviation of daily stock market returns, volatility's new-found popularity owes much to the 2008 financial crisis, when the returns on domestic equities and a great many traditional alternative investments became highly correlated. Volatility, however, did just the opposite-it became increasingly negatively correlated with stocks as the crisis deepened. Volatility diversification has potentially important implications for risk management in multi-asset portfolios, such as target-date and target-risk funds. These strategies are intended to greatly simplify asset allocation decisions for investors, and are based on institutional investment management concepts like broad asset diversification and portfolio risk reduction over time. Volatility diversification is appealing in this context precisely because it holds out the possibility of reducing risk in a more efficient manner than do many traditional portfolio diversifiers. In this paper, we will discuss the opportunities and challenges associated with incorporating volatility as a hedge in multi-asset portfolios. First, we present material on the history and evolution of the concept of volatility as a portfolio diversifier. Readers familiar with the concept of volatility in multi-asset portfolios may skip this material and begin with Part Two, in which we examine the potential diversification benefits of an allocation to volatility in balanced portfolios. In Part Three, we look at why volatility diversification may make the most sense for target-date funds (TDFs) in the crucial years around the target date, as well as assessing applications to global asset allocation portfolios. Finally, in Part Four, we present potential methods for incorporating volatility as a portfolio hedge, discussing the hurdles associated with each approach.

"The purpose of the Summit is to discuss key issues facing investors and to facilitate the evolution of private equity by exploring the latest research" said Jonathan Rosenthal, the Summit Founder/Co-Chair and Co-Managing Partner at Saybrook Capital. It is designed to spur dialogue between industry thought leaders and institutional private equity investors, many of whom were in attendance at this year's event, including Washington State Investment Board, Meketa Group and CIO of Fire and Police Pension Commissioners of the City of Los Angeles.

According to UCLA Anderson Professor and Summit Co-Chair Mark Garmaise, the Private Equity Summit is a unique event.

"Here leading academics and investors are able to consider the future of private equity by wrestling with hard data," he said. "The industry has been the subject of close attention in the last few months, but many of the popular descriptions are catchy sound bites rather than considered judgments. The PE Summit delves into the nuances of private equity from a research-based perspective."

Andy Rice, Chairman of the Association for Corporate Growth and a Senior Vice President at The Jordan Company, echoed Professor Garmaise's observations.

"The PE Summit is different, almost entirely focused on building better partnerships between limited partners, managers, and the academic researchers who study the industry, "he said. "This effort could do much to improve the long term return for investors and result in more private capital for growing companies."

Summit presentations covered a variety of critical topics ranging from the current state of raising funds in the private equity sector and the effects private equity has on employment to challenges of complying with the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among the presenters were Harvard Professor Josh Lerner, who delivered the key note with his research on private equity's impact on employment. Mark O'Hare, CEO of Preqin, the industry's leading data provider, lead a discussion on the creation of a private equity index, which may help investors assess the role and performance of private equity in their portfolios, supporting the trend towards increased allocations and returns. Purdue Professor Mara Faccio presented evidence that returns to private equity in Europe are significantly higher than returns to publicly traded equity. University of Virginia Professor David Smith examined the ramifications of leverage on private equity sponsored companies.

"This is the kind of dialogue private equity professionals ought to be engaged in," said Tim Recker, chairman of the Institute of Limited Partners Association (ILPA). "I am looking forward to participating next year".

Congratulations to all the winners of UCLA Anderson's first national stock pitch competition!

On March 9th, 2012, Anderson hosted teams from top MBA schools around the country. The competition was sponsored by the Fink Center, and designed to showcase the finest of the next crop of talent entering the investment community through a real-world simulation of the Wall Street decision-making process.

Each team consisted of three students interested in pursuing careers in investment research/asset management. Teams made stock pitch presentations to a distinguished panel of judges from the industry that involved rigorous analyses for a long or short investment from a pre-defined industry list selected by the judges in the first round.

In the final round, teams pitched long/short/do not own positions for Netflix (NFLX) and fielded tough questions under intense scrutiny by investment professions. Team school affiliations were not revealed until the awards ceremony. The winning teams were awarded $10,000 in total. A huge thank you to our judges for their time and dedication:

The UCLA Anderson Private Equity Roundtable, co-sponsored by the Fink Center for Finance and Investments, the Investment Finance Association, and the Entrepreneur Association, took place on March 15th, 2012 at the Hyatt Regency Century Plaza Hotel. The roundtable featured a special Q&A with Joseph A. Dear, Chief Investment Officer of CalPERS, and was hosted by Anderson's Senior Associate Dean Dr. Al Osborne, Jr.

Mr. Dear, from his perspective as one of the largest Limited Partners for private equity funds, covered a wide-ranging list of topics, including the changing of fee structures in the past five years and the future of the private equity industry as a whole. The event was attended by over 40 professionals from various funds in the Southern California region and over 70 students from the UCLA Anderson School of Management. In addition to hearing Mr. Dear's insights on the industry, the event provided attendees the opportunity to ask him questions during the interactive Q&A segment of the evening, and to network with each other over three roundtable sessions.

4th Annual Southern California UCLA-USC-UCI FINANCE DAY

On April 27, 2012, the UCLA Anderson finance group hosted academics from USC and UCI to discuss relevant and groundbreaking research. Topics presented by Anderson finance faculty included "Financial Flexibility for Households" (Mark Garmaise), "Systemic Sovereign Credit Risk: Lessons from the U.S. and Europe" (Francis Longstaff), and "Search Fatigue" (Bruce Carlin). Over 60 faculty were in attendance. Copies of working papers can be provided upon request.

The Fink Center Anderson Student Asset Management (ASAM) Speaker Series invites leading investment managers to speak to a select group of MBA students interested in pursuing a career in investment management. The students are members of ASAM, who manage an investment fund that aims to provide a competitive rate of risk-adjusted return to its investors, and engage in experiential learning through firm visits and guest speakers. This past fall, the following speakers presented: Michael Martin, editor of Martin Kronicle (October 11) and Mark Perry, vice president at Centinela Capital Partners (October 25).

Date

Speaker

School

Paper

Sept. 30

Ed Van Wesep

University of North Carolina

The Timing of Pay

Oct. 7

Mark Westerfield

USC

Economic Ties: Evidence from Venture Capital Networks

Oct. 21

Andrew Hertzberg

Columbia Business School

Exponential Individuals, Hyperbolic Households

Oct. 28

Kenneth Ahern

University of Michigan

Who Writes the News? Corporate Press Releases During Merger Negotiations

Jason Hsu, adjunct assistant professor of finance at UCLA Anderson and Research Affiliates chief investment officer, received a Graham and Dodd Scroll Award, recognizing other outstanding articles. This award was for his September/October FAJ article, "A Survey of Alternative Equity Index Strategies," joint work with Research Affiliates Vice President Vitali Kalesnik and Research Associate Tzee-man Chow; and Bryce Little, graduate student at Texas A&M University.

Richard Roll, Joel Fried Chair in Applied Finance at UCLA Anderson and principal of Consultant Compensation Valuation, was named winner of the Graham and Dodd Best Perspectives Award, which recognizes timely, thought-provoking opinion, for his article, "The Possible Misdiagnosis of a Crisis" in the March/ April issue of the Financial Analysts Journal (FAJ), a publication of the CFA Institute.

The FAJ Advisory Council and Editorial Board selected the winners. The award, created in 1960, honors "the enduring contributions of Benjamin Graham and David L. Dodd, legendary investors, to the investment analysis field," according to another CFA Institute statement.

Professor Andrea Eisfeldt Awarded Reaearch Grant from Bank of France

Andrea Eisfeldt, associate professor at UCLA Anderson, was awarded a 30,000 euro grant from the Bank of France for her project on "Liquidity and Fragility in OTC Credit Derivatives Markets," joint work with Andrew Atkeson and Pierre-Olivier Weill. In the paper, they develop and search a matching model of a derivatives trading network that illustrates some of the costs and benefits of the current structure of the OTC credit derivatives market. They find that the concentrated market provides liquidity, but can be fragile because banks' private benefits to trading are less than the social benefits their intermediation provides.

On May 29, 2012, AQR Capital Management, LLC today presented its first annual AQR Insight Award to Bryan Kelly of the University of Chicago and Seth Pruitt of the Federal Reserve Board of Governors for their innovative and practical unpublished research in predicting market returns more accurately over onemonth and one-year time horizons. The AQR Insight Award is designed to encourage and honor academics who are impacting the world of investing.

Among hundreds of submissions from 24 countries, the AQR Insight Award Committee chose five finalists, who presented their research on April 27, 2012 in Greenwich, Connecticut. "It was a privilege to host these talented academics, and the interactive exchange was compelling and productive," said David Kabiller, founding principal at AQR. "We were inspired by the innovation and insights of the work. It is our hope that this engagement will also make us better investors."

Hanno Lustig, associate professor at UCLA Anderson, earned an honorable mention for his research, "Countercyclical Currency Risk Premia", joint work with Nikolai Roussanov of University of Pennsylvania and Adrien Verdelhan of MIT. AQR Capital Management is a global investment management firm employing a disciplined and analytical research process to macroeconomic and fundamental data. As of March 31, 2012, AQR manages approximately $51.8 billion worldwide for institutional investors, including pensions, insurance companies, endowments, foundations and sovereign wealth funds, as well as registered investment advisors. Founded in 1998, AQR is based in Greenwich, Connecticut, with offices in Chicago, London and Sydney.